What should I know before starting a Hedge Fund?

I want to start a quantitative fund where decisions are made through data science and operations research methods. What I really want to know are about things that only the ones in the industry (or have been) would know - clients, legal requirements, managing personnel, etc...

Some Context:I don't think I'm one of those clueless kids who have an unrealistic dream of creating the next DE Shaw or Two Sigma. My fund would likely be trying to go for 10~30% each year. I'll mostly likely be hiring various engineers, data science, and operations research professionals + business and banking types for client mgmt and various other functions.

But, what I am is a "kid"; Fresh out of college, on my first job quantitative enough to help me get into a top PhD program. Realistically, I'll be working in the HF industry for a couple years to see how the sausage is really made.So what that means is that, it'll take 7-10 years before I actually start a fund.

I already developed a method for one of my strategies that seems to be working well and will test out with my own portfolio for the next few years.

Comments (29)

I have know a few friends who own and manage hedge funds so I think I can give you some good advice. A hedge fund basically gathers money from individuals and institutional investors that invest in a multitude of asset classes with the with portfolio management and risk opportunities that will be profitable. Do you have anyone who be willing to invest in your fund?

2/20 2% annual management fee and 20% is charged when Assets under management fee when a certain profit. Do you know anyone to invest in your hedge fund?

You need to get capital. Without that it doesn't matter how good your strategy is. This is the hard part.beyond that, there are consultants that will handle compliance (SEC registration? State registration?), lawyers that will handle formation, administrators that will handle the payouts. This is the easy part.

Without a route to capital, like a personal/professional network, you will have a tough road. Good luck.

Cap intro isn't likely to touch you unless you either have 5M+ with the prime broker, or have someone high up vouch for you(pedigree).If you are really 7 years out the best thing I think you can do is research strategies and network with people who have access to cash.

You say you're not looking to create the next DE Shaw or Two Sigma, but they return 10%-30%. However, I think quants miss how important sales/client relations are. Every fund goes through a period of sluggish returns, and you overcome this with excellent client relations.

I mean Bridgewater hasn't made anything for clients in a decade. Though very consistent 3% return.

Then they have a weird up 14% fourth quarter followed by down 5% first half. Seems like they gathered assets and took no risks then went big bear for 9 months. But basically not even beating a 30 year treasury buy and hold fo that time period.

What I meant by not being the next big XYZ was that it's not my goal to be as notable as such funds nor have their AUM. I like to keep it fairly unknown (by the general public) while still getting a solid return.

Of course, I'll have to do some more research to see what returns are expected given my strategies and it's risk profile.

I can help you a little bit. As a hedge fund, you're expected to have a Sharpe ratio of 1 to 2 and zero correlation to equities or bonds. You can still charge 2/20 for this. Some "hedge funds" have leaders numbers but charge less as well.

I would advise that you shoot for a quant PM position first at a multimanger like cubist/de shaw/2s. The fundraising environment for new hedge fund launches is pretty terrible at the moment and is not forecasted to improve in the near future. Running a hedge fund is similar to running a small business, with all the headaches of paperwork, payroll, compliance, and managing the back office. On the other hand, you could just trade for a MM and earn your 10-20% cut in pass-through fees, without having to worry about any of the silly logistics of running your own small business. If at a later point, you want to branch out and start your own fund, you will have a track record to point to when fundraising, which is a basic requirement nowadays.

Finally, I think you have unrealistic expectations about performance. Starting with $100M in AUM, earning 20%/year on average would lead you to become emperor of the world by the time your lifespan expires. Most MMs would give their PMs a 2.5% vol target on $250-500M of AUM. Assuming you have a 1-2 sharpe ratio, that's $6-25M of PNL per year, of which you might take home $1-5M. LPs have gotten smarter over the past 20 years. They don't tolerate double digit drawdowns anymore, they won't tolerate beta disguised as alpha, and they won't invest with someone running a 20% vol target.

Does this sound boring to you? That's the way the industry is headed. Instead of one genius with a 2 sharpe strategy on 20% vol, LPs prefer handing 30 1 sharpe (correlated) traders a 2.5% vol target. Pension funds just need a steady 7% return so they can justify their boss's extremely high choice of discount factor. A cowboy who makes 20%/year with some double digit drawdowns is not what they're looking for.

Wow this has been quite helpful in terms of the industry environment. 10%-30% is of course a stretch.If my hypothesis is correct, my strategies should be fairly market neutral and mostly depend on outcomes of various discrete events. I'll have to spent a lot more time to really understand the risk profiles and estimate what returns I can expect to make, which I believe should be fairly constant over several years until underlyong dynamics of the market change.

As others have alluded to here, raising capital is hard. Very very hard. There are plenty of people out there with pedigree and claimed track records who struggle to raise capital, and end up joining a family office, forming their own, or much more often, going to an MM.

Investors now not only want risk-adjusted returns (ala Millennium etc) but also want robust back office processes and compliance especially post-Madoff. All of that costs a lot of money and resources (ie. people) that most start-ups don't have/can't afford. As a result of general lackluster performance from HFs over the last decade, many investors are also not as willing to pay the standard 2/20, at least not on day 1. One may be able to raise capital from fund of funds, private banks, HNWIs, family offices etc, who can be more flexible and far less demanding re the back office/compliance etc. But these investors can be flaky and the capital could be redeemed tomorrow.

The prized investors are the pensions, endowments etc. and they will usually demand a lot of resources to satisfy. Think about it from the perspective of some guy sitting at a pension. He is making $150k-$300k (latter if senior) and works nice hours. Job is pretty recession resistant, he's not a risk taker, and has a good work/life balance. Why on Earth would he stick out his neck and choose an unproven start-up fund and take that career risk when he could just chose a Millennium/Citadel etc. What's the upside for him? We know what the downside is, and that is the start-up doesn't do well, has numerous other risks and the fund could blow up. And he loses his job. OR he can go with the safe big choice that everyone else is in and if they do badly, well everyone else is facing the same issue right? Dude keeps his job.

This means that the big HFs who have done ok/well, made some money and have kept investors and have all of the infrastructure in place will continue to get bigger. That means that (with some exceptions) that start-up funds will often struggle to raise capital or will usually have a longer gestation period in which they will need to prove themselves in order to raise a meaningful amount of capital and that it will be a slog.

Having sat in an allocator seat in a previous life and with many friends still in the space, it's amazing to see how many choices of funds there are to choose from. And how few are actually any good for a sustained period of time (yes the definition of "good" can vary, amongst other things - but let's keep it simple).

High priced products (regardless of industry) need to deliver. Hedge funds are high priced products and many have not. This is not to be discouraging but just a heads up to understand how challenging it may be to raise a fund and scale it.